Principle of Rational Choice in Economics: Theory & Analysis

Instructor: Wren Hawthorne
Economic theory is based on several important concepts. One of those concepts is that people make choices in their best self-interest. This is known as the Rational Choice Theory. We will explore this concept in more detail in this lesson.

What is Economic Theory?

Have you ever wondered why the cost of tea goes up along with the cost of coffee? Perhaps you want to understand why those hard-to-find concert tickets are so expensive? These are the types of things that economists love to explore, and they do so through economic theory. Simply put, the aim of economic theory is to examine the supply and demand of goods and services.

However, before economic theorists can start to examine these situations, there are several underlying questions that need to be addressed. One of the underlying questions is:

How do people go about deciding between different options when making choices about how to spend their money?

For example, let's say that you have saved $15,000 over the last several years, and you now face the decision of what to do with that money - don't we all wish to be in this situation! What theories could help explain how you will choose to spend your money?

One theory might be that your choice on how to spend the money is a random one. Perhaps you will flip a coin and if you get heads you will purchase a new car, and if you get tails you will give the money away to charity. This doesn't seem like a very robust theory, does it? In fact, if choices were random, the theory can't really go any further in explaining how you will choose to spend your money.

Another theory may be that you will choose to spend your money in a way that will be in the best interest of your neighbor. You notice that your neighbor could use a new roof, and you have saved up the exact amount that will buy her a new roof. This theory has some merit. Perhaps you are a very altruistic person and often make decisions based on what is best for others.

However, economists believe there is a reason that better explains why people make the choices they do. From observing people's behavior, economists believe the best theory for why individuals make economic decisions is that they make choices that are in their best self-interest. This is called rational choice theory.

Rational Choice Theory - What's in it For Me?

Continuing our scenario, rational choice theory states you will make a choice that maximizes your own happiness. For example, you determine that in looking at all of your needs, a new car is your top priority. It is in your best interest to use your savings to purchase this new car. The idea that you make choices that make you better off is the basis of the theory of rational choice.

A Real World Example - Outdoor Markets

Shoppers at one of the open-air fruit stalls at a market in Jerusalem, Israel

Have you ever been to a swap meet? These are places were people can rent a table for a few dollars and sell whatever items they have available to offer. For example, people might sell fresh fruits and vegetables, clothing, chickens, goats, books, and electronics. If you go to a swap meet, you could spend your money on a new book, a video game, or simply a candy bar.

Swap meets are an example of rational choice theory. When you go to them, you are likely to choose to buy items that are in your own self-interest. Furthermore, the individuals selling those items to you do so because it is in their self-interest to have the money from those items to use in some other way.

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